Taylor Miller v. Commissioner

T.C. Memo. 2001-55UNITED STATES TAX COURT
TAYLOR MILLER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12095-98. Filed March 6, 2001.
Patrick W. Martin, for petitioner.
Timothy F. Salel, for respondent.
MEMORANDUM OPINION
BEGHE, Judge: Respondent determined a deficiency of $75,180
in petitioner’s 1992 Federal income tax. The deficiency is
primarily attributable to respondent’s determination that the
proceeds of petitioner’s settlement of a sex discrimination class
action lawsuit, Kraszewski v. State Farm Gen. Ins. Co., 38 Fair
Empl. Prac. Cas. (BNA) 197 (N.D. Cal. 1985), affd. in part, revd.
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in part and remanded 912 F.2d 1182 (9th Cir. 1990) (the State
Farm class action lawsuit), are included in her gross income.1
Petitioner concedes that the gross proceeds of her
settlement of the State Farm class action law suit--$283,543--are
not excluded from her gross income under section 104(a)(2),2 but
she attacks the validity of respondent’s notice of deficiency on
multiple grounds: That respondent violated his reopening
procedures, that respondent performed a second inspection of
petitioner’s books of account in violation of section 7605(b),
and that respondent is equitably estopped from issuing the notice
of deficiency. Petitioner also claims, if the validity of the
notice should be sustained, that she is entitled to deduct, as
section 162 business expenses, two items she did not claim on her
1992 income tax return: Her contribution to a private pension
plan and her attorney’s fees and costs in the State Farm class
action lawsuit.
We sustain the validity of respondent’s notice and reject
petitioner’s claims to the private pension plan contribution
1
For a description of the State Farm class action lawsuit
in the context of the claimants’ income tax treatment, see Brewer
v. Commissioner, T.C. Memo. 1997-542, affd. without published
opinion 172 F.3d 875 (9th Cir. 1999).
2
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect during the year in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
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deduction and above-the-line treatment of the deduction for her
attorney’s fees and costs, which respondent allowed in the notice
of deficiency as an itemized deduction subject to the 2-percent
limitation of section 67.
Some of the facts have been stipulated and are so found.
The stipulations of fact and accompanying exhibits are
incorporated by this reference. For clarity and convenience,
findings of fact and discussion with respect to the validity of
respondent’s notice and petitioner’s deduction claims are
combined under two separate headings. Monetary amounts have been
rounded to the nearest whole dollar.
Petitioner resided in Poway, California, when the petition
in this case was filed.
Issue 1: Validity of Statutory Notice
During 1975, petitioner sold insurance products as an
employee of Fidelity Union Life Insurance Company (Fidelity).
During 1976 and 1977, petitioner operated as a sole owner and
paid for the costs of operating her business as an independent
insurance salesperson with Fidelity. Petitioner reported her
1976 and 1977 earnings from the sale of Fidelity insurance
products on Schedule C of her 1976 and 1977 Federal income tax
returns. After 1977, petitioner never again sold insurance, but
worked off and on, sometimes as an employee and sometimes as an
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independent contractor, in various selling jobs in, among other
things, the financial products, mortgage brokerage, and real
estate businesses.
In fall 1976 or January 1977, petitioner applied to become a
State Farm trainee agent. As part of her job application,
petitioner had a series of interviews and took a test with State
Farm. Petitioner was never hired by State Farm, nor did she ever
provide services for State Farm.
In 1988, petitioner applied to become a class member of the
State Farm class action lawsuit and thereafter became a class
member. On March 6, 1992, petitioner executed a settlement
agreement and general release (settlement agreement), regarding
her claim in the State Farm class action lawsuit. In the
settlement agreement, petitioner and State Farm characterized the
settlement as “the compromise of a claim for agent earnings”; by
entering into the settlement agreement, petitioner waived “any
and all right she might have * * * respecting instatement”.
Petitioner received a $223,935 check from the law firm of
Saperstein, Mayeda, Larkin, and Goldstein as the net proceeds of
settlement of her claim in the State Farm class action lawsuit.
Petitioner has stipulated that she received $283,543 as the gross
proceeds of the settlement (not reduced by attorney’s fees and
costs) during the 1992 tax year. Of that amount, State Farm
reported $283,178 on Form 1099-MISC and the remaining $425 on
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Form W-2. State Farm negotiated and reported the $283,178 of
settlement proceeds on Form 1099-MISC as the amount it would have
paid petitioner if she had become its independent insurance
agent. State Farm negotiated and reported the $425 of settlement
proceeds on Form W-2 with payroll taxes properly withheld as the
amount it would have paid petitioner if it had initially hired
her as a trainee agent.
Petitioner timely filed her Federal income tax return, Form
1040, for the 1992 tax year with the Internal Revenue Service
Center in Fresno, California. Petitioner attached to her 1992
return a Schedule C and a Form 8275 disclosure statement
reporting her receipt of settlement proceeds of $1,383,118 from
State Farm companies in 1992 on account of personal injuries or
sickness from a “very serious auto accident and an intentional
personal discrimination claim”, which were excludable from gross
income under section 104(a)(2). Of this total amount, petitioner
received approximately $1,100,000 from State Farm Mutual Auto
Insurance Company in settlement of a claim for personal injuries
suffered in an auto accident. These personal injury settlement
proceeds are not at issue in this case.
On October 7, 1993, respondent’s District Director mailed
petitioner a letter and Information Document Request (Form 4564)
informing her that her 1992 income tax return had been selected
for examination. On April 8, 1994, petitioner’s counsel mailed
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respondent a 16-page memorandum arguing that the State Farm class
action lawsuit settlement proceeds received by petitioner are
excluded from gross income under section 104(a)(2). On April 25,
1994, respondent mailed petitioner a “no change” form letter
(Letter 590 (DO) (Rev. 4-92)) stating: “We examined your tax
return for the above period and made no changes to the tax year
reported.” Respondent’s form letter goes on to advert to the
possibility of a later change in the taxpayer’s tax if the
taxpayer is a shareholder of an S corporation, a beneficiary of a
trust, or a partner in a partnership whose return is changed on
examination.
Respondent and petitioner never executed a closing
agreement, pursuant to section 7121, for petitioner’s 1992 tax
year.
On March 29, 1995, respondent’s Fresno Service Center mailed
petitioner a 30-day letter regarding her alleged failure to
report bartering proceeds of $2,894 on her 1992 income tax return
for the 1992 tax year. The 30-day letter regarding the bartering
proceeds was unrelated to the examination regarding the State
Farm class action lawsuit settlement proceeds. On April 19,
1995, petitioner’s representative, David W. Stevenson, C.P.A.
(Stevenson), in response to this 30-day letter, mailed a letter
to respondent’s Fresno Service Center, attaching thereto copies
of the Schedule D of petitioner’s 1992 income tax return and the
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front page of the 30-day letter. After receiving Stevenson’s
letter, respondent agreed that petitioner had properly reported
$2,894 in bartering proceeds on Schedule D of her 1992 income tax
return.
On September 28, 1995, respondent’s District Director
mailed petitioner a 30-day letter for the 1992 tax year regarding
the State Farm class action lawsuit settlement proceeds. The
statement of examination changes accompanying this 30-day letter
proposed to treat petitioner’s State Farm class action lawsuit
settlement proceeds, in the amount of $283,117, as income from
self-employment for the 1992 tax year, and to allow legal fees of
$56,623 paid to obtain the settlement as an above-the-line
Schedule C deduction. This 30-day letter proposed no adjustment
related to bartering proceeds.
In November 1995, petitioner and her counsel signed a
Consent to Extend the Time to Assess Tax (Form 872) that extended
the period of limitations on assessment for the 1992 tax year
until June 30, 1997.
On July 17, 1996, a tax technician in respondent’s District
Director’s Office mailed petitioner’s counsel a letter enclosing
a revised examination report (not included in the record)
deleting self-employment tax on the settlement proceeds and
downgrading petitioner’s legal fees from an above-the-line
Schedule C deduction to a below-the-line itemized deduction. The
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letter also asserted that two criteria applied in respondent’s
decision “to reopen Ms. Miller’s case for re-examination”:
First, there had “been a substantial error both in amount and in
relation to total tax liability” and, second, “other
circumstances exist indicating that failure to reopen the case
would be a serious administrative omission”.
On October 2, 1996, petitioner signed another Consent to
Extend the Time to Assess Tax (Form 872), which extended the
period of limitations on assessment for the 1992 tax year until
April 30, 1998.
On January 16, 1997, petitioner’s counsel mailed
respondent’s Riverside, California, Appeals Office a 9-page
memorandum arguing two grounds on which the no change letter
should stand. The first ground was that there was no justifiable
basis for reopening the case under Rev. Proc. 94-68, 1994-2 C.B.
803, and section 4023 of the Internal Revenue Manual (the
Manual), which in his view were binding on the Internal Revenue
Service. The second ground was that respondent had conducted a
second investigation of petitioner’s 1992 return, without
notifying her of the need thereof, in violation of section
7605(b).
On June 16, 1997, the Chief, Examination Division, Laguna
Niguel, California, mailed petitioner a letter stating, with
regard to the 1992 tax year:
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We are required by law to notify taxpayers in
writing if we need to reexamine their books and records
after previously examining them.
Because information that may affect your tax
liability has been developed since we last examined
your books and records, please make them available to
us for reexamination.
Thank you for your cooperation.
On October 14, 1997, petitioner signed another Consent to
Extend the Time to Assess Tax (Form 872), which extended the
period of limitations for assessment for the 1992 tax year until
December 31, 1998.
On April 9, 1998, respondent issued the notice of deficiency
for the 1992 tax year to petitioner. When respondent issued the
notice, the period of limitations for assessment for the 1992 tax
year had not expired.
Petitioner claims she relied on respondent’s April 25, 1994,
no change letter for “a sense of security,” but she did nothing
in detrimental reliance thereon. For some years, petitioner has
been her mother’s primary source of support; petitioner’s income
tax returns for the years 1989 through 1996 claim her mother as a
dependent. Commencing early in the calendar year 1998,
petitioner became the primary source of support for one of her
nephews.
To provide the context for respondent’s change of the
position evidenced by the no change letter, we make some
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preliminary observations. In 1993, when respondent notified
petitioner that her 1992 return had been selected for
examination, continuing through 1994, when respondent mailed
petitioner the no change letter, it was respondent’s stated
position that a payment in satisfaction of a sex discrimination
claim under Title VII of the Civil Rights Act of 1964, as amended
in 1991 to provide for compensatory and punitive damages and for
jury trials, was excluded from gross income as damages for “tort-
like personal injury” under section 104(a)(2). See Rev. Rul. 93-
88, 1993-2 C.B. 61; see also Priv. Ltr. Rul. 94-48-014 (Aug. 30,
1994). In taking this position, respondent relied on language in
United States v. Burke, 504 U.S. 229, 234-241 (1992), which held
that back-pay damages under the pre-1991 version of Title VII of
the Civil Rights Act of 1964 were taxable because that version of
the Act, which provided neither for damages other than backpay
nor for a jury trial, did not redress a tort-like injury.
Petitioner’s counsel’s legal memorandum of April 8, 1994,
argued that petitioner’s settlement proceeds from the State Farm
class action lawsuit remedied a tort-like injury and were
excluded from gross income under section 104(a)(2), pursuant to
Rev. Rul. 93-88 and Priv. Ltr. Rul. 94-48-014. In issuing the no
change letter, respondent apparently accepted petitioner’s
argument that petitioner’s claim in the State Farm class action
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lawsuit was governed by the 1991 amendments to the Civil Rights
Act.3
Any uncertainty about the significance in discrimination
cases of the 1991 amendments to the Civil Rights Act was laid to
rest by the Supreme Court’s opinion in Commissioner v. Schleier,
515 U.S. 323 (1995), published June 14, 1995. Schleier held that
awards under the Age Discrimination in Employment Act (ADEA) were
taxable not only because the ADEA, like the pre-1991 version of
the Civil Rights Act, does not satisfy the requirement of tort-
like injury, but also because the claim must be “on account of
personal injuries or sickness”, and that termination on account
of age could not “fairly be described as a ‘personal injury’ or
‘sickness.’” Id. at 330. Thus, the second ground of Schleier
3
If respondent accepted petitioner’s argument to this
effect, relying on the holding of the Court of Appeals for the
Ninth Circuit in Davis v. City of San Francisco, 976 F.2d 1536(9th Cir. 1992) (cited by petitioner’s counsel in his memo of
April 8, 1994), that the provisions of the Civil Rights Act of
1991, Pub. L. 90-202, 81 Stat. 602, governing expert witness fees
applied retroactively, it turned out that respondent was
mistaken. The amendments made by the Civil Rights Act of 1991,
which provided for additional relief of compensatory and punitive
damages as well as back pay, and for a jury trial, were
subsequently held not to apply retroactively. See Landgraf v.
USI Films Prods., 511 U.S. 244, 249, 256, 286 (1994). Thus,
respondent should have considered petitioner’s claim in the light
of the pre-1991 version of the Act under which she made claim,
which arose in 1977. See Clark v. Commissioner, T.C. Memo. 1997-
156. Since United States v. Burke, 504 U.S. 229 (1992), held
that sec. 104(a)(2) did not apply to a settlement award under
Title VII of the 1964 Act, Burke was governing authority for
inclusion of petitioner’s settlement in gross income.
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supports the proposition that back wages for what might be
regarded as a tort-like injury, e.g. discrimination on account of
age, race, disability, or sex, are taxable unless it can be shown
that (a) the discrimination caused physical or psychological
injury, and (b) the loss of pay was due to a physical or
psychological injury, not just the discriminatory action of the
employer.4
Schleier became the law of the land applicable to all
pending cases. When the U.S. Supreme Court announces a rule of
law and applies it to the litigants in the case announcing the
rule, that rule applies retroactively to all other pending cases
unless barred by the statute of limitations or res judicata. See
Harper v. Virginia Dept. of Taxation, 509 U.S. 86, 97 (1993);
James B. Beam Distilling Co. v. Georgia, 501 U.S. 529, 540-541,
544 (1991). Consistently with this view, the Tax Court has
applied Schleier to taxable years antedating the Supreme Court’s
opinion therein. See, e.g., Bagley v. Commissioner, 105 T.C. 396(1995), affd. 121 F.3d 393 (8th Cir. 1997); Green v.
Commissioner, T.C. Memo. 1998-274; Goeden v. Commissioner, T.C.
Memo. 1998-18; Wise v. Commissioner, T.C. Memo. 1998-4; Kroposki
4
It is noteworthy that the Supreme Court in Schleier v.
Commissioner, 515 U.S. 323, 336 n. 8 (1995) cast doubt on the
Commissioner’s reading of United States v. Burke, supra, in Rev.
Rul. 93-88, 1993-2 C.B. 61. In Notice 95-45, 1995-2 C.B. 330,
the Commissioner suspended Rev. Rul. 93-88; in Rev. Rul. 96-65,
1996-2 C.B. 6, the Commissioner obsoleted Rev. Rul. 93-88.
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v. Commissioner, T.C. Memo. 1997-563; Moran v. Commissioner, T.C.
Memo. 1997-412; Fredrickson v. Commissioner, T.C. Memo. 1997-125.
The Tax Court has also invariably held that recipients of
settlement proceeds from the State Farm class action lawsuit are
required to include the proceeds in gross income. See, e.g.,
Westmiller v. Commissioner, T.C. Memo. 1998-140; Reiher v.
Commissioner, T.C. Memo. 1998-75; Easter v. Commissioner, T.C.
Memo. 1998-8; Brewer v. Commissioner, T.C. Memo. 1997-542, affd.
without published opinion 172 F.3d 875 (9th Cir. 1999); Gillette
v. Commissioner, T.C. Memo. 1997-301; Hayes v. Commissioner, T.C.
Memo. 1997-213; Hardin v. Commissioner, T.C. Memo. 1997-202;
Raney v. Commissioner, T.C. Memo. 1997-200; Clark v.
Commissioner, T.C. Memo. 1997-156; Berst v. Commissioner, T.C.
Memo. 1997-137; Martinez v. Commissioner, T.C. Memo. 1997-126,
affd. without published opinion 83 AFTR 2d 99-362, 99-1 USTC par.
50,168 (9th Cir. 1998); Fredrickson v. Commissioner, supra.
Approximately 3 months after the Supreme Court’s opinion in
Schleier, respondent mailed petitioner the 30-day letter of
September 28, 1995, which proposed that the proceeds of her
settlement of the State Farm class action lawsuit be included in
her gross income. Thereafter, petitioner signed a series of
consents extending the period of limitations on assessment for
the 1992 tax year; in due course, in 1998, respondent issued the
notice, which embodies respondent’s determination to give effect
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to the proposal in respondent’s 30-day letter of September 28,
1995.
Before turning to petitioner’s three arguments that
respondent’s statutory notice is invalid, we recite some events
in the administrative history of the case noted by the parties in
making their arguments.
Before mailing the 30-day letter of September 28, 1995, in
which respondent first proposed, after mailing petitioner the no
change letter, that the State Farm class action lawsuit
settlement proceeds should be included in her gross income,
respondent issued a 30-day letter, on March 29, 1995, to the
effect that she had failed to include $2,894 of bartering
proceeds in her 1992 return. Petitioner’s representative
resolved that issue simply by sending respondent a copy of the
Schedule D on which the bartering proceeds were reported.
Petitioner now claims that respondent’s raising of the bartering
proceeds issue was a prohibited second examination without
petitioner’s consent in violation of section 7605(b).
On July 17, 1996, after the 30-day letter of September 28,
1995, and the parties’ execution of the first consent extending
the period of limitations, a tax technician in respondent’s
District Director’s Office mailed petitioner’s attorney a letter
that on balance was more unfavorable to petitioner than the 30-
day letter: Although the new letter said the recovery was not
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subject to self-employment tax, it downgraded her attorney’s fees
from an above-the-line Schedule C deduction to a below-the-line
itemized deduction, which increased her adjusted gross income and
limited her available exemptions. The letter also recited the
two criteria justifying respondent’s change of the position
evidenced by the no change letter.
In response to petitioner’s counsel’s second memo of
January 16, 1997, arguing that neither of those criteria had been
satisfied and that petitioner had not been notified of the need
for a second examination, respondent’s Chief, Examination
Division, on June 16, 1997, mailed petitioner a letter belatedly
acknowledging that “We are required by law to notify taxpayers in
writing if we need to reexamine their books and records after
previously examining them” and asking petitioner to “please make
them available to us for examination”. There is no evidence in
the record that respondent ever actually reexamined petitioner’s
records or requested any additional documentation from petitioner
regarding the State Farm class action lawsuit settlement
proceeds.
Although there may be some interrelationships among
petitioner’s arguments that the notice should be invalidated on
account of respondent’s asserted failure to follow his reopening
procedures, respondent’s asserted violation of section 7605(b),
and petitioner’s claim of equitable estoppel, see Saltzman, IRS
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Practice and Procedure 8-42 (2d ed. 1991), we follow the lead of
the parties and address these arguments under separate
subheadings.
a. Respondent’s Asserted Failure To Follow Reopening
Procedures
Respondent’s procedural rules for reopening cases closed
after examination to make an adjustment unfavorable to the
taxpayer are set forth in the latest of a long line of revenue
procedures, Rev. Proc. 94-68, 1994-2 C.B. 803, and in section
4023 of the Manual.
The Service’s policy is not to reopen a closed case to make
an adjustment unfavorable to the taxpayer unless
(1) there is evidence of fraud, malfeasance,
collusion, concealment, or misrepresentation of a
material fact;
(2) the prior closing involved a clearly defined
substantial error based on an established Service
position existing at the time of the previous
examination; or
(3) other circumstances exist that indicate
failure to reopen would be a serious administrative
omission. [1 Audit, Internal Revenue Manual (CCH),
sec. 4023.2 (Reopening Requirements), at 7063-7064.]5
The revenue procedure and the Manual clarify the reopening
procedures. The closing of a case by the Service is evidenced,
among other things, by issuance of a no change letter to the
taxpayer. See Rev. Proc. 94-68, sec. 4.01(1), 1994-2 C.B. 803; 1
5
Rev. Proc. 94-68, sec. 5.01 (Policy), 1994-2 C.B. at 804,
is virtually identical.
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Audit, Internal Revenue Manual (CCH), sec. 4023.4, at 7064-7065.
A no change letter is not a closing agreement under section 7121.
See sec. 301.7121-1(d), Proced & Admin. Regs.
i. Violation of Respondent’s Reopening Procedures Does Not
Invalidate a Notice of Deficiency.
In the face of hornbook law that respondent’s procedural
rules, including the reopening procedures under Rev. Proc. 94-68
and section 4023.2 of the Manual, supra, are merely directory,
not mandatory, see Collins v. Commissioner, 61 T.C. 693, 700-701
(1974), and that compliance with directory procedural rules is
not essential to the validity of a statutory notice, so that an
alleged violation of these rules provides no basis for
invalidating a statutory notice of deficiency, id., petitioner
cites Chrysler Corp. v. Brown, 441 U.S. 281 (1979), for the
proposition that respondent’s reopening procedures in Rev. Proc.
94-68, 1994-2 C.B. 803, should have “the force and effect of
law”.
Chrysler Corp. v. Brown, 441 U.S. at 302 (quoting Morton v.
Ruiz, 415 U.S. 199, 232, 235, 236 (1974)), establishes that a
regulation or procedure has the force and effect of law when it
is promulgated by an agency as a “‘substantive rule’” or a
“‘legislative-type rule’” pursuant to a mandate or delegation by
Congress “‘affecting individual rights or obligations.’”
Conversely, “interpretive rules, general statements of policy, or
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rules of agency organization, procedure, or practice” are not
binding upon the agency. Id. at 301. Courts have long
recognized the distinction between mandatory procedures, which
are binding on the agency, and directory procedures, which are
not. See Cleveland Trust Co. v. United States, 421 F.2d 475 (6th
Cir. 1970); Geurkink v. United States, 354 F.2d 629 (7th Cir.
1965); Luhring v. Glotzbach, 304 F.2d 560 (4th Cir. 1962);
Collins v. Commissioner, supra; Notaro v. United States, 71 AFTR
2d 93-659, 93-1 USTC par. 50,030 (N.D. Ill. 1992); First Fed.
Sav. & Loan Association v. Goldman, 58 AFTR 2d 86-5612, 86-2 USTC
par. 9624 (W.D. Pa. 1986).
We are satisfied under the weight of authority that we need
not reexamine the well-established law to this effect. However,
for purposes of completeness, we do address petitioner’s argument
that respondent violated respondent’s own reopening procedures,
so as to demonstrate the inapplicability of any isolated cases in
which the Commissioner’s notice was arguably held invalid for
failure to follow his own reopening procedures. See, e.g.,
Estate of Michael ex rel. Michael v. Lullo, 173 F.3d 503 (4th
Cir. 1999). We conclude that in the case at hand respondent
satisfied at least one of the criteria under his procedures for
reopening a closed case.
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ii. Respondent Did Not Violate His Reopening Procedures in
Reopening Petitioner’s 1992 Tax Year.
Whether respondent was justified under Rev. Proc. 94-68 and
section 4023 of the Manual, supra, in reopening petitioner’s
“closed” case would depend upon whether respondent’s original
position (1) was attributable to taxpayer or Service misconduct,
(2) constituted “substantial error,” or (3) whether respondent’s
failure to change the position would have constituted “a serious
administrative omission”. Satisfaction of any of these three
tests would justify reopening under the Service’s own policy
pronouncements. See supra p. 16.
We focus on the third test, whether “failure to reopen
would” have been “a serious administrative omission.” Reopening
because of a “serious administrative omission” covers situations
in which a failure to reopen could:
(1) result in serious criticism of the Service’s
administration of the tax laws;
(2) establish a precedent that would seriously
hamper subsequent attempts by the Service to take
corrective action;
(3) result in inconsistent treatment of similarly
situated taxpayers who have relatively free access to
knowledge as to how the Service treated items on other
taxpayers’ returns. [1 Audit, Internal Revenue Manual
(CCH), sec. 4023.5, at 7065.]
With regard to “serious administrative omission”, we
conclude that respondent is on firm ground. Whatever doubt there
might have been about the clarity of respondent’s established
position in 1994, those doubts were laid to rest and the position
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clarified in mid-1995 by the Supreme Court’s opinion in
Commissioner v. Schleier, 515 U.S. 323 (1995). Petitioner
acknowledges that the State Farm class action lawsuit settlement
proceeds constitute gross income, and we are satisfied that
respondent was authorized to pursue all recipients of such
proceeds, including petitioner, for all open years. For
respondent not to have done so might well have resulted “in
serious criticism of the Service’s administration of the tax
laws” and would have resulted “in inconsistent treatment of
similarly situated taxpayers”, thereby satisfying the first and
third criteria for application of the “serious administrative
omission” test. Petitioner’s anecdotal testimony that some
members of the class got away with noninclusion of their
settlement proceeds because respondent failed to pursue them does
not change our conclusion that the third test was satisfied.
Section 4023.5 of the Manual, in its “Definition of
Reopening Criteria”, contains neither the conjunction “and” nor
the disjunctive connector “or” between the second and third
criteria. 1 Audit, Internal Revenue Manual (CCH), sec. 4023.5,
at 7065. We are satisfied that the three criteria are to be
interpreted and applied as setting forth their requirements in
the disjunctive. What this means is that the satisfying of any
one of the three criteria suffices to satisfy respondent’s
“serious administrative omission” reopening test. Inasmuch as at
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least one of the criteria for a “serious administrative omission”
was satisfied, respondent’s self-imposed stated conditions for
reopening petitioner’s 1992 tax case were satisfied.
b. Second Inspection
Section 7605(b) provides:
No taxpayer shall be subjected to unnecessary
examination or investigations, and only one inspection
of a taxpayer’s books of account shall be made for each
taxable year unless the taxpayer requests otherwise or
unless the Secretary or his delegate, after
investigation, notifies the taxpayer in writing that an
additional inspection is necessary.
The purpose of section 7605(b) is not to limit the number of
examinations, but to shift the discretion for a reexamination of
the taxpayer’s books to higher management personnel from the
field agent; this serves “to emphasize the responsibility of
agents to exercise prudent judgment in wielding the extensive
powers granted to them by the Internal Revenue Code.” United
States v. Powell, 379 U.S. 48, 56 (1964). Section 7605(b) was
not meant to restrict the scope of respondent’s legitimate power
to protect the revenue. See id. Section 7605(b) is not to be
read so broadly as to defeat the powers granted to respondent to
examine the correctness of a taxpayer’s return. See De Masters
v. Arend, 313 F.2d 79, 87 (9th Cir. 1963).
There is no evidence in the record of a second inspection as
contemplated by section 7605(b), irrespective of whether
petitioner is arguing that respondent’s reopening of the
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treatment of the State Farm class action lawsuit settlement
proceeds or the raising of the bartering proceeds issue was a
prohibited second inspection. A second inspection would require,
at a minimum, that respondent have access to and physically view
petitioner’s books and records for the 1992 tax year. See
Benjamin v. Commissioner, 66 T.C. 1084, 1098 (1976), affd. on
other grounds 592 F.2d 1259 (5th Cir. 1979).
Petitioner argued, in her counsel’s memo of January 16,
1997, that respondent had failed to notify her in writing of the
need for a second inspection. Respondent, through the Chief,
Examination Division, belatedly responded, in respondent’s letter
of June 16, 1997, reciting the section 7605(b) requirements and
asking petitioner to “please make [her books and records]
available to us for examination.” Respondent’s response was
wholly unnecessary. There is no evidence in the record that
respondent actually reexamined petitioner’s records or requested
or received any additional documentation from petitioner
regarding the State Farm class action lawsuit settlement proceeds
after issuance of the no change letter.
Apparently recognizing the weakness of her original position
on the issue, petitioner on the day of trial chose to rely on
respondent’s inquiry raising the bartering proceeds issue as the
prohibited second examination. On this score, petitioner fares
no better. In resolving the bartering proceeds issue, respondent
- 23 -
merely reviewed Schedule D of petitioner’s 1992 income tax return
and the letter from petitioner’s representative. Respondent’s
review of a taxpayer’s income tax return and accompanying
schedules does not constitute a second inspection of the
taxpayer’s books of account under section 7605(b). See Curtis v.
Commissioner, 84 T.C. 1349, 1351 (1985); Pleasanton Gravel Co. v.
Commissioner, 64 T.C. 510, 528 (1975), affd. per curiam 578 F.2d
827 (9th Cir. 1978). Since there was no second inspection or
examination, respondent’s inquiry, following the no change
letter, into the bartering proceeds issue without a prior written
justification did not violate section 7605(b). See Digby v.
Commissioner, 103 T.C. 441, 451 (1994).
Even if respondent should be deemed to have performed a
second inspection in raising the bartering proceeds issue, it was
done with the knowledge of petitioner, who raised no objection
thereto prior to the morning of trial. Consequently, petitioner
waived the requirement of written notice prior to a second
inspection. See Rife v. Commissioner, 41 T.C. 732, 747 (1964),
affd. on this issue 356 F.2d 883 (5th Cir. 1966); Rice v.
Commissioner, T.C. Memo. 1994-204.
Moreover, even if respondent should be deemed to have
performed a second inspection on the bartering proceeds issue
without prior notification that petitioner did not waive,
invalidation of the notice of deficiency would not be the proper
- 24 -
remedy. No remedy would be warranted. There was no adjustment
in the deficiency notice related to the bartering proceeds issue;
petitioner suffered no injury as a result of the alleged
violation of section 7605(b). See Rice v. Commissioner, supra at
note 11 and cases cited therein.
c. Respondent Is Not Equitably Estopped From Issuing the
Notice of Deficiency.
“Equitable estoppel is a judicial doctrine that ‘precludes a
party from denying his own acts or representations which induced
another to act to his detriment.’” Hofstetter v. Commissioner,
98 T.C. 695, 700 (1992) (quoting Graff v. Commissioner, 74 T.C.
743, 761 (1980), affd. 673 F.2d 784 (5th Cir. 1982)). The
traditional elements of equitable estoppel--all of which must be
satisfied to invoke the doctrine--are: (1) A false
representation or misleading silence by the party against whom
the doctrine is to be invoked; (2) an error in a statement of
fact and not an opinion or statement of law; (3) ignorance of the
fact by the representee; (4) reasonable reliance on the act or
statement by the representee; and (5) detriment to the
representee. See Norfolk S. Corp. v. Commissioner, 104 T.C. 13,
60 (1995), affd. 140 F.3d 240 (4th Cir. 1998).
Equitable estoppel may not be asserted against the
Government “‘on the same terms as any other litigant’”. United
States v. Hatcher, 922 F.2d 1402, 1410 (9th Cir. 1991) (quoting
- 25 -
Heckler v. Community Health Servs., 467 U.S. 51, 60 (1984)). The
doctrine of equitable estoppel is applied against respondent
“with utmost caution and restraint.” Schuster v. Commissioner,
312 F.2d 311, 317 (9th Cir. 1962), affg. 32 T.C. 998 (1959),
affg. in part and revg. in part First W. Bank & Trust Co. v.
Commissioner, 32 T.C. 1017 (1959). Estoppel may be successfully
invoked against the Commissioner only where a taxpayer would
otherwise sustain such a “profound and unconscionable injury in
reliance on the Commissioner’s action as to require, in
accordance with any sense of justice and fair play, that the
Commissioner not be allowed to inflict the injury.” Id. This
rarely happens; the policy in favor of the efficient collection
of public revenue usually outweighs the customary policy
considerations that justify invocation of equitable estoppel as
between private litigants. See id.In addition to the traditional elements of equitable
estoppel, the Court of Appeals for the Ninth Circuit requires the
party seeking to apply the doctrine against the Government to
prove affirmative misconduct. See Purcell v. United States, 1
F.3d 932, 939 (9th Cir. 1993), and cases cited. The aggrieved
party must prove “‘affirmative misconduct going beyond mere
negligence’” and, even then, “‘estoppel will only apply where the
government’s wrongful act will cause a serious injustice, and the
public’s interest will not suffer undue damage by imposition of
- 26 -
the liability.’” Purer v. United States, 872 F.2d 277, 278 (9th
Cir. 1989) (quoting Wagner v. Director, Fed. Emergency Mgmt.
Agency, 847 F.2d 515, 519 (9th Cir. 1988)). Affirmative
misconduct requires “ongoing active misrepresentations” or a
“pervasive pattern of false promises,” as opposed to an isolated
act of providing misinformation. Watkins v. United States Army,
875 F.2d 699, 708 (9th Cir. 1989). Affirmative misconduct is a
threshold issue to be decided before determining whether the
traditional elements of equitable estoppel are present. See
Purcell v. United States, supra at 939.
Before beginning the inquiry into whether the no change
letter satisfied the conditions for invoking equitable estoppel
against respondent, we must isolate and characterize the
representation, if any, made by the no change letter. The letter
says two things: “We examined your * * * return * * * and made
no changes to the tax year reported”, and it alerts the taxpayer
to the possibility of a later change if the Service makes a
change on examination of an S corporation, trust, or partnership
of which the taxpayer is a shareholder, beneficiary, or partner.
The letter thereby creates an impression that the return will not
be changed in any other circumstances, but this is more a
possible inference from silence than an affirmative
representation. In this respect, the letter is different from
the estate tax closing letters that were considered in Estate of
- 27 -
Michael ex rel. Michael v. Lullo, 173 F.3d 503 (4th Cir. 1999);
Trust Servs. of Am. v. United States, 885 F.2d 561 (9th Cir.
1989); Estate of Brocato v. Commissioner, T.C. Memo. 1999-424;
Law v. United States, 51 AFTR 2d 1343, 83-1 USTC par. 13,514
(N.D. Cal. 1982). The format of the estate tax closing letter,
as described or quoted in these cases, is to state that the
estate tax return has either been accepted as filed or after
adjustment to which the taxpayer agreed, to recite that the
letter is not a closing agreement under section 7121, and to
state that “we will not reopen this case” unless the three-prong
test set forth in the revenue procedure currently in effect is
satisfied, either by quoting the test or citing the revenue
procedure.
Petitioner fails to satisfy the strict standard for
equitable estoppel against the Government for at least three
reasons. First, as a threshold matter, there is no evidence of
ongoing active misrepresentations, a pervasive pattern of false
promises, or any affirmative misconduct by respondent. See Purer
v. United States, supra at 278.
Second, however the statements in the no change letter might
be characterized, petitioner has not demonstrated reliance on the
no change letter in changing her behavior to her detriment. In
order to satisfy the requirement of reliance, petitioner must
show that she changed her behavior as a result of the alleged
- 28 -
misrepresentation. See Heckler v. Community Health Servs., 467
U.S. 51, 61 (1984). While petitioner claims that she relied on
the no change letter for “a sense of security”, there is no
evidence that she changed her behavior or did anything in
reliance on the no change letter, much less that she did anything
to her detriment. See Keaton v. Commissioner, T.C. Memo. 1993-
365; Nadler v. Commissioner, T.C. Memo. 1992-383.
Petitioner’s claims that she relied on the no change letter
in continuing to save her investments, and in continuing to care
for her mother, do not hold water. Petitioner continued to save
her investments and care for her mother after she received the no
change letter in the same ways she did before she received it.
Petitioner’s continued behavior does not establish the change in
position that petitioner must establish in order to prove
reliance. See Heckler v. Community Health Servs., supra at 61.
Petitioner also claims that petitioner relied on the no
change letter in deciding to take custody of her nephew shortly
before June 1998. However, before petitioner took custody of her
nephew, she had signed consents extending the period of
limitations on assessment on November 4, 1995, on October 2,
1996, and on October 14, 1997. Petitioner took custody of her
nephew shortly after respondent issued the notice of deficiency
for this case on April 9, 1998. Since petitioner was aware of
the pending examination of her income tax return for 1992, and
- 29 -
had already received the notice when she accepted custody of her
nephew, petitioner’s claim of reliance on the no change letter is
not credible. See Levin v. Commissioner, T.C. Memo. 1990-226(taxpayer who executed two extensions of the period of
limitations did not establish reliance on a closing document).
Third, any reliance on the no change letter was not
reasonable. A no change letter, as distinguished from a closing
agreement under section 7121, does not resolve a tax controversy
with finality. See Opine Timber Co. v. Commissioner, 64 T.C.
700, 712-713 (1975), affd. without published opinion 552 F.2d 368(5th Cir, 1977); Kiourtsis v. Commissioner, T.C. Memo. 1996-534;
Fitzpatrick v. Commissioner, T.C. Memo. 1995-548. Even after she
received the no change letter, petitioner was aware that the 1992
tax year remained open. Petitioner signed three consents to
extend the time to assess tax (Form 872). The period of
limitations on assessment for the 1992 tax year had not expired
at the time respondent issued the notice of deficiency in this
case. Accordingly, even if petitioner did rely on the no change
letter, her reliance was not reasonable.
We deny petitioner’s claim for the application of equitable
estoppel against respondent to invalidate the statutory notice.
Issue 2: Amount and Character of Allowable Deductions
The validity of respondent’s statutory notice having been
upheld, the conclusion follows, as petitioner concedes, that the
- 30 -
proceeds of settlement of her claim in the State Farm class
action lawsuit must be included in her 1992 gross income. We are
therefore faced with petitioner’s alternative arguments that she
is entitled to a substantial deduction in arriving at her 1992
taxable income for her contributions to the TJM pension plan and
that her attorney’s fees are an above-the-line Schedule C
deduction rather than an itemized deduction subject to the 2-
percent floor of section 67. These two arguments have a common
thread, that petitioner should be allowed to treat her settlement
recovery as if it were earnings from rendering services as an
independent contractor insurance agent for State Farm.
a. Deduction Disallowed for Private Pension Plan
Contributions
On October 30, 1992, petitioner adopted the Taylor J. Miller
Defined Benefit Pension Plan (TJM Pension Plan).
According to the adoption agreement, petitioner adopted and
sponsored the TJM Pension Plan as a sole proprietorship in her
own name. Petitioner did not operate a sole proprietorship
during 1992 or 1993.
The Adoption Agreement for the TJM Pension Plan selected
November 1, 1991, as the effective date and defined the term
"plan year" as the fiscal period ending on October 31 of each
calendar year.
- 31 -
The TJM Pension Plan was a volume-submitter plan known as
the Harrigan, Ruff, Ryder & Sbardellati Master Defined Benefit
Pension Plan and Trust Agreement. On April 12, 1994, respondent
issued an opinion letter that the Harrigan, Ruff, Ryder &
Sbardellati Master Defined Benefit Pension Plan and Trust
Agreement documents satisfied the requirements of the Internal
Revenue Code (without opining on the qualified status of
individual plans using the document).
In 1995, petitioner applied for a determination letter for
the TJM Pension Plan. On February 8, 1996, respondent mailed
petitioner a favorable determination letter that the TJM Pension
Plan was qualified under section 401.
Petitioner retained an enrolled actuary, Stephen L. Hawkins,
to prepare the Actuarial Information (Schedule B, Form 5500) for
the TJM Pension Plan for the plan years ending October 31, 1992,
and October 31, 1993.
The first plan year for the TJM Pension Plan ended October
31, 1992. Petitioner submitted TJM Pension Plan's Annual Return
of Fiduciary of Employee Benefit Trust (Schedule P Form 5500),
the Return/Report of Employee Benefit Plan (Form 5500-C/R), the
Actuarial Information (Schedule B, Form 5500), and the
Application for Extension of Time To File Certain Employee Plan
Returns for the plan fiscal year ending October 31, 1992. On the
Return/Report of Employee Benefit Plan (Form 5500-C/R),
- 32 -
petitioner used business code No. 8999, meaning "other services
not classified."
The second plan year for the TJM Pension Plan ended October
31, 1993. At trial, petitioner submitted the TJM Pension Plan's
Annual Return of Fiduciary of Employee Benefit Trust (Schedule P,
Form 5500), the Return/Report of Employee Benefit Plan (Form
5500-C/R), the Actuarial Information (Schedule B, Form 5500), and
the Application for Extension of Time To File Certain Employee
Plan Returns for the plan fiscal year ending October 31, 1993.
Petitioner made the following deposits into a trust bank
account at Wells Fargo Bank titled in the name of Taylor J.
Miller, Trustee, Taylor J. Miller Defined Benefit Pension Plan
(TJM Pension Plan Account):
Date Amount
December 31, 1992 $ 2,500
January 8, 1993 88,594
91,094
On January 8, 1993, petitioner transferred $85,000 from the
TJM Pension Plan Account to Jack White & Company. Schedule B for
the plan year ending October 31, 1992, showed that petitioner
made the following contributions to the TJM Pension Plan:
Date Amount
December 31, 1992 $ 2,500
January 8, 1993 38,229
40,729
Based on the plan provisions and assumptions used by the
actuary for the TJM Pension Plan plan year ending October 31,
- 33 -
1992, the full funding limitation under sections 412 and 404 was
$40,729. For purposes of this case, under section
404(a)(1)(A)(i), the full funding limitation would result in a
maximum deductible contribution of $40,729 for the plan year
ending October 31, 1992.
Schedule B for the plan year ending October 31, 1993, showed
that petitioner made the following contribution to the TJM
Pension Plan:
Date Amount
January 8, 1993 $50,365
Based on the plan provisions and assumptions used by the
actuary for the TJM Pension Plan plan year ending October 31,
1993, the full funding limitation under sections 412 and 404 was
$52,443. For purposes of this case, under section 404(a)(1)
(A)(i) and section 1.404(a)-14(c), Income Tax Regs., the full
funding limitation would result in a maximum deductible
contribution of $52,443 for the plan year ending October 31,
1993.
During 1975, petitioner earned $12,895 in wages from
Fidelity; petitioner earned no self-employment income. During
1976 and 1977, respectively, petitioner earned $4,849 and $1,059
in net self-employment income from sales of Fidelity insurance
products. Petitioner had no self-employment income for the 1989
tax year. For the 1990 and 1991 tax years, petitioner reported
- 34 -
net losses from self-employment on Schedule C of $4,769 and
$3,981, respectively.
The only receipts that petitioner reported on Schedule C of
her 1992 income tax return were the settlement proceeds of her
auto accident personal injury claim and the settlement proceeds
of the State Farm class action lawsuit. She lumped these
together and reported the sum as subject to “exclusion under
section 104(a)(2) (see 8275)”. On her 1992 income tax return,
petitioner reported her occupation as “Investor”.
Petitioner earned no income from self-employment for the
1993, 1994, and 1995 tax years. On her income tax returns for
these years, petitioner reported her occupation as “Investor”.
On the Schedule C to her 1996 income tax return, petitioner
reported a $5,364 net loss from self-employment; she reported her
occupation as “Investor”.
At no time did petitioner perform services for State Farm.
Petitioner did not work in the insurance industry after 1977.
Petitioner did not claim any deduction for contributions to a
pension plan on her income tax return for the 1992 tax year.
In her petition, filed with this Court on July 7, 1998,
petitioner raised the issue of the deductibility of her pension
plan contributions for the first time. In her petition,
petitioner claimed a deduction for her 1992 tax year for $91,094
in total contributions to the TJM Pension Plan. The $91,094 in
- 35 -
total contributions consists of $40,729 in contributions for the
plan year ending October 31, 1992, and a $50,365 contribution for
the plan year ending October 31, 1993. Petitioner concedes, if
we should hold that she had earned income in 1992 in respect of
which she could make a deductible contribution to the TJM Pension
Plan, that the contribution deduction would be limited to a
lesser amount as calculated under section 1.404(a)-14(c), Income
Tax Regs.
The TJM Pension Plan was not in effect for the 1991 tax year
because petitioner did not have a written plan and trust in
existence in 1991. The TJM Pension Plan continues to remain in
effect, although petitioner has not made any subsequent
contributions to the trust under the plan.
A self-employed taxpayer may be entitled to deduct from
income her contributions to a qualified plan, provided that the
deduction does not exceed the earned income derived from the
taxpayer’s trade or business with respect to which the plan is
established. See secs. 401(c), 404(a)(1), and (a)(8). “Earned
income” is defined in section 401(c)(2)(A), which states in
relevant part: “The term ‘earned income’ means the net earnings
from self-employment (as defined in section 1402(a)), but such
net earnings shall be determined * * * only with respect to a
trade or business in which personal services of the taxpayer are
- 36 -
a material income-producing factor.” Sec. 401(c)(2)(A)
(emphasis added).
Petitioner seeks to deduct her contributions to the TJM
Pension Plan on the ground that the settlement proceeds of the
State Farm class action lawsuit should be characterized as earned
income from self-employment.
Petitioner argues that the definition of net earnings from
self-employment should be broadly construed, citing Wuebker v.
Commissioner, 110 T.C. 431 (1998), particularly with regard to
insurance agents, citing Jackson v. Commissioner, 108 T.C. 130(1997), and Schelble v. Commissioner, 130 F.3d 1388 (10th Cir.
1997), affg. T.C. Memo. 1996-269. Although Wuebker and Jackson
did not hold in favor of inclusion, Schelble did, and there are
other cases that lend support to the traditional justification
for a broad approach to promote the inclusion of self-employed
individuals in the Social Security system and to finance Social
Security benefits to be paid to them. See, e.g., Milligan v.
Commissioner, 38 F.3d 1094 (9th Cir. 1994).
In support of the application of the “origin of the claim”
test to hold that the settlement proceeds qualify as earnings
from self-employment, petitioner also cites Dye v. United States,
121 F.3d 1399, 1404 (10th Cir. 1997), which quoted the District
Court as follows:
- 37 -
the object of the “origin of the claim” test is to find
the transaction or activity from which the taxable
event proximately resulted, United States v. Gilmore,
372 U.S. 39, 47, * * * (1963), or the event that “led
to the tax dispute.” Keller St. Dev. Co. v.
Commissioner, 688 F.2d 681 (9th Cir. 1982). The origin
is determined by analyzing the facts and determining
what the nature of the transaction is. Keller, 688
F.2d at 681.
Although petitioner in the agreement settling her claim in
the State Farm class action lawsuit waived all rights to be hired
by State Farm, the agreement characterized the settlement as “the
compromise of a claim for agent earnings.” Petitioner cites
McKay v. Commissioner, 102 T.C. 465 (1994), vacated and remanded
in an unpublished opinion 84 F.3d 433 (5th Cir. 1996); Metzger v.
Commissioner, 88 T.C. 834 (1987), affd. without published opinion
845 F.2d 1013 (3d Cir. 1988); and Yates Indus., Inc. v.
Commissioner, 58 T.C. 961 (1972), for the propositions that this
Court, in making its facts and circumstances analysis of the
origin of a claim, not only gives great deference to the terms of
a settlement negotiated at arm’s length, but that in these cases
“this Court determined that the parties [sic] specific allocation
of the settlement proceeds should be respected as it accurately
reflected the origin of the claim and the settlement of those
proceeds.”
We have here some tensions between the initial positions of
Congress and the Commissioner, restricting the availability of
qualified plans for the self-employed because of the tax shelter
- 38 -
they can provide for highly compensated individuals, such as
physicians and lawyers,6 with petitioner’s reminder that the
Court has more recently recognized that highly compensated self-
employed individuals are entitled to use such plans, including
properly structured defined benefit plans, to shelter their
earned income and provide for retirement within the limits
established by Congress. See Vinson & Elkins v. Commissioner, 99
T.C. 9 (1992). Petitioner couples her reminder with the argument
that, as a victim of invidious discrimination that prevented her
from achieving an independent contractor relationship in the
insurance industry, she should be allowed to treat her
compensatory recovery as self-employment income and thereby
shelter a portion of the recovery by making deductible
contributions to her qualified plan. Cf. Sager & Cohen, “How the
6
See Staff of the Joint Comm. on Taxation, General
Explanation of the Revenue Provisions of the Tax Equity and
Fiscal Responsibility Act of 1982, at 301-308 (J. Comm. Print
1982), setting forth the various restrictions in prior statutory
law on qualified plans for the self-employed. See also Bittker &
Lokken, Federal Taxation of Income, Estates and Gifts S90-4-S90-5
(Cum. Supp. No. 2, 2000) for a brief summary, with citations to
relevant authorities, of the Commissioner’s efforts to limit the
use by the erstwhile self-employed of professional corporations
as vehicles to obtain the tax benefits of qualified pension and
profit-sharing plans.
- 39 -
Income Tax Undermines Civil Rights Law”, Tax Notes 1643
(Sept. 25, 2000).
Unfortunately for petitioner, the governing statutory
language does not allow us to disregard its plain meaning. The
problem with petitioner’s arguments and authorities is that they
derive no support from and indeed are contradicted by the
statutory and regulatory language as construed by the Tax Court.
Section 1.401-10(c)(1), Income Tax Regs., interprets “earned
income,” as used in section 401(c)(2)(A), quoted supra p. 35, and
section 1402(a). The regulation provides that an individual who
renders no personal services has no “earned income” even though
such an individual may have net earnings from self-employment
from a trade or business. Earned income includes professional
fees and other amounts received as compensation for personal
services “actually rendered” by the individual. Id.
Accordingly, if a self-employed taxpayer has not rendered
personal services in the trade or business for which a plan is
established, then the taxpayer has no earned income and is not
entitled to deduct contributions to the plan. See S. Rept. 992,
87th Cong., 1st Sess. 12 (1961), 1962-3 C.B. 303, 314 (“the
measuring rod for deductible contributions for self-employed
* * * [taxpayers] is ‘earned income’ * * *. This means that
contributions by or for a proprietor or partner may be made under
- 40 -
a qualified retirement plan only if he performs personal
services”).
We have found no case in which a person’s desire,
willingness, or intent to render personal services satisfied the
earned income requirement. Instead, we have upheld the
requirement that personal services be actually performed in order
to yield earned income that will support a deduction under
section 404.
In Kramer v. Commissioner, 80 T.C. 768 (1983), Jack Kramer,
a former U.S. tennis champion, received royalty payments from
Wilson Sporting Goods, a tennis racquet manufacturer, which were
attributed to the use of his name and reputation, and for
services actually rendered in promoting Wilson’s premier tennis
racquet, which bore his name. We made an allocation between the
royalties paid for the use of Kramer’s name and reputation, which
were not earned income, and royalties paid for promotional
services actually rendered on Wilson’s behalf, which were earned
income. We held that, to the extent the royalties did not
qualify as earned income, Kramer was not entitled to take them
into account in computing his deductible contributions to his
Keogh plan.
Similarly, in Frick v. Commissioner, T.C. Memo. 1983-733,
affd. without published opinion 774 F.2d 1168 (7th Cir. 1985),
the Court denied Mr. Frick’s claimed Keogh plan contribution
- 41 -
deduction to the extent his contributions were from investment
income. This was because the investment income was not derived
from personal services. In so ruling, we quoted the legislative
history of section 401(c), which states: “Since the objective of
* * * [a qualified plan for the self-employed] is to provide
retirement benefits based on personal services, inactive owners
who derive their income entirely from investments would not be
allowed to participate.” S. Rept. 992, 87th Cong., 1st Sess. 12
(1961), 1962-3 C.B. 303, 314; see also Frick v. Commissioner,
T.C. Memo. 1985-542, affd. without published opinion 808 F.2d 837(7th Cir. 1986); Frick v. Commissioner, T.C. Memo. 1989-86, affd.
without published opinion 916 F.2d 715 (7th Cir. 1990).
In the case at hand, petitioner applied to become a State
Farm trainee agent in fall 1976 or January 1977. However,
petitioner never performed any services for State Farm, either as
employee or as independent contractor. After 1977, she never
worked in the insurance industry, although from time to time
thereafter she worked in various selling jobs, sometimes as
employee and sometimes as independent contractor. As in the
Kramer and Frick cases, the income paid by State Farm to
petitioner in the case at hand cannot be earned income because it
- 42 -
was not paid as compensation for personal services actually
rendered.7
The settlement proceeds received by petitioner do not meet
the personal service requirements for earned income set forth in
section 401(c)(2), section 1.401-10(c)(1), Income Tax Regs., and
the relevant case law.
Inasmuch as the State Farm settlement proceeds do not
constitute income from self-employment within the meaning of
section 401(c)(2) or section 1402(a), petitioner is not entitled
to deduct the contributions to her defined benefit plan, the TJM
Pension Plan. We therefore need not address the question briefed
by the parties regarding the limitations on the contribution
deduction.
b. Character of Deduction for Legal Fee
Petitioner presented no evidence and requested no findings
of fact on this issue and pays scant attention to it in her
briefs. In her briefs, petitioner concludes by doing no more
than asserting: “petitioner should be entitled to a deduction
* * * of $58,459.24 for attorneys’ fees and costs without regard
to the limitation under I.R.C. § 67.”
7
Because the State Farm settlement proceeds were not the
result of personal services actually rendered by petitioner, we
need not determine the precise nature of the settlement proceeds
or specifically characterize the settlement proceeds as a
particular type of income. See Gump v. United States, 86 F.3d
1126, 1130 (Fed. Cir. 1996).
- 43 -
In so asserting, petitioner has conceded that she is not
entitled to exclude her share of the attorney’s fees in the State
Farm class action lawsuit in computing her gross income from the
settlement. Petitioner’s concession is well taken. Both the
Court of Appeals for the Ninth Circuit and this Court have
consistently held that contingent fees paid to recover a claim to
income are not excluded in computing the gross income from the
recovery, not even in a class action such as in the case at hand,
where the claimant retains even less control over the prosecution
and settlement of the claim than she would in ordinary one-on-one
litigation. Compare Estate of Clarks v. United States, 202 F.3d
854 (6th Cir. 2000), and Cotnam v. Commissioner, 263 F.2d 119(5th Cir. 1959), with Benci-Woodward v. Commissioner, 219 F.3d
941, 943 (9th Cir. 2000), affg. T.C. Memo. 1998-395; Coady v.
Commissioner, 213 F.3d 1187 (9th Cir. 2000), affg. T.C. Memo.
1998-291; Kenseth v. Commissioner, 114 T.C. 399 (2000); Brewer v.
Commissioner, T.C. Memo. 1997-542, affd. without published
opinion 172 F.3d 875 (9th Cir. 1999); Martinez v. Commissioner,
T.C. Memo. 1997-126, affd. without published opinion 83 AFTR 2d
99-362, 99-1 USTC par. 50,168 (9th Cir. 1998). See also Banks v.
Commissioner, T.C. Memo. 2001-48.
Although the legal expenses of an independent contractor in
prosecuting a claim arising from the conduct of his Schedule C
trade or business are entitled to above-the-line treatment as
- 44 -
business expenses, see Guill v. Commissioner, 112 T.C. 325(1999), we have denied petitioner’s pension contribution
deduction on the ground that the recovery in her settlement of
the State Farm class action lawsuit did not constitute earned
income from services actually rendered by her in conducting a
Schedule C business. There was no nexus between the recovery and
the rendering of any personal services by petitioner to the
payor. The nexus was different; the recovery was connected to,
had its origin in, and arose out of State Farm’s invidious
discrimination, which deprived her of the opportunity to perform
any such services.
Our denial of petitioner’s claim to a pension plan
contribution deduction on that ground forecloses her claim that
she is entitled to an above-the-line Schedule C deduction for
legal fees, rather than the itemized deduction subject to the 2-
percent limitation of section 67 that respondent allowed in the
statutory notice.
To give effect to all the foregoing,
Decision will be entered for
respondent.